By Christopher Carosa, CTFA | April 4, 2012While the four steps to a well-documented 401k investment due diligence process just fell in our laps, getting into the nitty-gritty of the first two steps – the identifying the selection and monitoring processes – might prove a tad bit more cumbersome. There’s another thing about this particular portion of the due diligence process you must be warned about. It’s the part where the arguments start.

If you take any two investment advisers and ask them which specific characteristics one should focus on when selecting a mutual fund to be included among a 401k plan’s investment options, you’re likely to get vastly different answers. Fortunately, in speaking to different advisers, we’ve been able to whittle down their recommendations to very broad areas – wide enough for most advisers to swim comfortably within.

So, if you’re looking for a fight, you won’t find one here.

I. Company’s Custom Statistics – It all starts here, with specific data pertaining to the company’s demographics. This data set will produce the major criteria 401k plan sponsors – or their advisers – will later use when determining appropriate fund options. Todd Reid, General Agent for Intermountain Financial Group in Salt Lake City, Utah says this will indicate the “time horizon, liquidity, and true risk tolerance” of the plan’s investors; hence, act as a great starting point towards selecting funds.II. Company’s Goal-Oriented Target Analysis – While company demographics are generic, it’s important to recognize that even employees of the same age may have difference return requirements. In order to best select relevant funds for the plan option, it’s critical to know the range of target returns. This will come in handy during the later performance analysis of each candidate fund.III. Key Characteristics of the Fund – Before even getting into performance and costs, it’s important to identify a set of key differentiators you’ll review among all funds, whatever the investment objective. Boyd Wagstaff, 401k and Qualified Plan Specialist for Intermountain Financial Group, likes to focus in on the fund managers. He looks at years of tenure and style. “We want to make sure that fund or investment is true to its value,” he says. “For example, if we are looking for a large-cap value stock, we want to make sure it does not change to some other style, but that it remains consistent with its original design.”IV. Peer Group Performance – Manny Schiffres, Executive Editor, Kiplinger’s Personal Finance in Washington, D.C. says, “We look at performance, specifically the consistency of performance. How has a fund done year by year against its peer group and an appropriate benchmark is far more important than cumulative results, which can be swayed by one outstanding year.”V. Rolling Long-Term Performance – This approach to performance measurement is more consistent with the results of studies in behavioral finance as it dodges the dangers of short-term volatility and avoids the “snapshot-in-time” phenomenon Schiffres refers to. He says, “Analysis of the sort that says this or that fund has beaten its peers or an index over the past 1, 3, 5 and 10 years is bogus. As mentioned earlier, one outstanding (or awful) year totally distorts the numbers. Plus, because this sort of analysis can change depending on whether a fund is strong at the beginning or the end of the period, even if the results are essentially the same in either case, it is obviously a flawed approach to analyzing performance.”VI. Generic Fund Statistics – All funds share common traits. Some of them may reveal characteristics the plan sponsor will want to shun or emphasize. Among these can include the number of holdings (addressed previously in “Overdiversification and the 401k Investor – Too Many Stocks Spoil the Portfolio”), the concentration of holdings, the fund’s size and any unique costs associated with the fund. When it comes to a fund’s size, Schiffres says “The bigger the fund, the harder it is to manage. This is especially true when the fund focuses on less-liquid investments, stuff other than big-cap stocks and Treasury bonds. When you buy in big quantities, you tend to force up the price of the security you’re buying. When you dump large quantities, you help push down the price. Neither is helpful to the manager.” Regarding costs, besides the usual expense ratio, Reid also looks at the “sales charge in relation to the fund class, and available break points purchased. The different fund fees vary by Class A, B, and C. Some classes have front-end fees, while others do not. Service fees are also a piece of the fees needing to be considered and vary by manager, and length of deferred sales charge.”VII. Proprietary written description of Fund’s Investment Objective – These next four Commandments have one thing in common. They all rely on written documentation beyond the fund’s prospectus. While plan sponsors must read the prospectus, they must also remember the prospectus is inherently a sales tool. Getting a third party’s opinion can often help the plan elude the seemingly attractive pitch of an inappropriate fund. Sometimes this third party view comes from an adviser, sometimes it comes from a publisher. Ideally, it will be proprietary in nature, aimed at the specific needs of the plan and not for the general mass market. The first detail the 401k plan sponsor will want to see is an objective description of the fund’s investment objective. That’s the basis of each of the next three items.VIII. Proprietary written analysis of Fund’s ability to meet its objective – Did the fund meet its objective? Plan sponsors should not count on the fund to tell them. Select an unbiased party. Reid uses these sources to “review the history, performance of sector, and scrutinize any drifting that may have occurred.” He says, “It is my duty to my clients to ensure them the funds stay true to their sector and that the allocations are relevant.”IX. Proprietary written commentary on Fund management – According to Schiffres, “the manager is the person responsible for the record.” He matter-of-factly says “past performance is not guaranteed. Expenses pretty much are baked into the cake. In other words, expenses are something you know in advance, so you want to keep them as low as possible. Of course, super-low expenses are the main justification for going with index funds. To recommend actively managed funds, you have to feel confident that you can identify managers you think are good enough to overcome their expense disadvantage.”X. Proprietary written recommendation of relative appropriateness – When all is said and done, a plan sponsor must always ask “Is it time to replace this fund?” Here it’s vitally important to have a wide variety of choice, since any limitations may expose the plan sponsor to greater fiduciary liability. Wagstaff says, “We use a variety of sources to compare and contrast. We use third-party resources and we look for balance. We don’t want to load the platform up with one type of fund. We prefer a large number of funds to cherry pick and collect a platform for our clients that we believe is cost appropriate, diversified, and with excellent returns.”

We trust this represents a Decalogue possessing both credence and compatibility. Not only does it make sense to use, but the vast majority of plan sponsors can easily adopt each category of scrutiny.

The habits of successful retirement plan advisers

By Donna Mitchell May 22, 2012 Leading retirement plan advisers exhibit several key differences in the way they approach their practice.

Successful advisers have more efficient practices, they keep up to speed on products and trends, are better positioned to withstand uncertain markets, and are better prepared to handle specific economic challenges like low interest rates, according to Cara Farchione, manager of retirement solutions for Raymond James.

Further, top advisers in the retirement plan area are less challenged by the practice management issues of working with lower income clients, and they feel more confident about their ability to ‘sell’ themselves and attract clients.

They also happen to have higher account balances and manage a significant greater share of their clients’ assets than their counterparts, Farchione said at Raymond James Financial Services' National Conference for Professional Development in Orlando on Monday.

Farchione cited research which found that about 81% of clients think a detailed retirement plan is important, yet only 18% of investors in that study concede that they have a plan. “It shows a clear gap in what the delivery is and what the client expectations are,” she said.

One of the ways in which financial advisers who work on retirement plan can begin to stand out from their peers is to get up to speed on the latest changes governing the Medicare program. Mercer, the consulting firm, supplies white papers and guides, plus letters and emails that advisers can send out to clients to bring them up to speed on how to navigate the changes.

There are other ways for advisers to distinguish themselves as reliable experts in this area. One attendee specifically mentioned that the Raymond James’ retirement framework simply and clearly explains to clients how their assets should be allocated in retirement. In the framework, a clients’ reliable income is designated as retirement income to pays for living expenses. Retirement assets are used to fill in any shortfalls from the reliable income stream, and the rest of the assets will buy the items or fund other nonessential items that the client wants.

MODEL PORTFOLIOS IN RETIREMENT PLANS

On May 7, 2012, the U.S. Department of Labor's (DOL) Employee Benefits Security Administration (EBSA) released Field Assistance Bulletin 2012-02, providing guidance in the form of frequently asked questions (FAQs) regarding the new participant investment and fee disclosure rules.

"This guidance will help both plan administrators and covered service providers comply with their obligations under the department's new fee-transparency rules, so that workers who make their own investment decisions in retirement plans will have the information they need to make informed investment choices," said Assistant Secretary of Labor for EBSA Phyllis C. Borzi. "We also are working on a second set of frequently asked questions and answers focused more narrowly on the new rules for disclosure by covered service providers." (Source: EBSA News Release, May 7, 2012)

Most notably, the guidance addresses how investment model portfolios offered in retirement plans should be disclosed under these new rules. Where models are comprised of different combinations of a plan's designated investment alternatives (e.g., mutual funds), then the model portfolio itself is not considered to be a designated investment alternative. In FAQ #28, the DOL states "A model portfolio ordinarily is not required to be treated as a designated investment alternative under the regulation if it is clearly presented to the participants and beneficiaries as merely a means of allocating account assets among specific designated investment alternatives."

On the other hand, the DOL states that models that are comprised of any investment options not otherwise offered to plan participants as a designated investment alternative are designated investment alternatives themselves. Lastly, they state that "if a participant is acquiring an equity security, unit participation, or similar interest in an entity, that, itself, invests in some combination of the plan's designated investment alternatives, such model portfolio ordinarily would be a designated investment alternative."

Regardless of whether a model is considered to be a designated investment alternative, the DOL points out that "the plan administrator should clearly explain how the model portfolio functions. When a model portfolio is simply a means of allocating account assets among specific designated investment alternatives, the plan administrator also must clearly explain how it differs from the plan's designated investment alternatives."

Whether a model is considered to be a designated investment alternative is a critical distinction because the regulations require that specific information be provided to plan participants regarding each designated investment alternative, including historical returns, expense information, benchmarks, and a website where the participants can go to access additional information regarding the option.

DOL rule threatens DC plan brokerage windows

'Surprise' contained in clarification of fee disclosure regulation

By Robert Steyer | May 28, 2012John DeanSurprising: Edward Ferrigno said the brokerage account guidance was unexpected.

The Labor Department's attempt to clarify upcoming defined contribution fee-disclosure regulations amounts to creating a new regulation for brokerage accounts without using the proper process, industry experts say.

“This is coming out of left field,” said Edward Ferrigno, Washington-based vice president for Washington affairs at the Plan Sponsor Council of America. He was referring to a May 7 DOL guidance document that discusses brokerage accounts and other elements of new rules affecting fee disclosure between sponsors and participants.

“This is breaking new ground that hasn't been discussed before,” said Larry Goldbrum, Washington-based general counsel for the SPARK Institute. Messrs. Goldbrum and Ferrigno agreed the guidance could discourage plans from adding brokerage windows to their DC investment lineups.

Other industry experts say the DOL comments on self-directed brokerage will cause more paperwork, cost, confusion and fiduciary responsibility for sponsors.

The Labor Department's timing is troublesome because Aug. 30 is the compliance deadline for rules affecting fee disclosure between sponsors and participants. “It was certainly a big curveball, and we certainly don't want curveballs at this stage,” Mr. Ferrigno said. Industry participants say the DOL's latest discussion of brokerage windows creates confusion when matched with rules on “designated investment alternatives” in the Employee Retirement Income Security Act. A “designated investment alternative” is any investment identified by a plan fiduciary — such as a collection of core funds — into which participants and beneficiaries can place their money.

The DOL guidance, called a Field Assistance Bulletin, reaffirmed that a brokerage window by itself is not a designated investment alternative. Nor is a self-directed brokerage account or any “similar plan arrangements that enable participants and beneficiaries to select investments beyond those designated by the plan.”

DC experts argue that other wording in the document indicates individual funds or stocks within the brokerage windows could be considered designated investment alternatives if a certain number of plan participants put their money into them.

The DOL has “introduced a new concept — the idea that an investment available in a self-directed brokerage account might need to be treated as a designated investment alternative without a fiduciary ever having designated it,” said Jennifer Eller, a principal with Groom Law Group, Washington, who specializes in fiduciary responsibility. “This is a designated investment alternative by people voting with their feet.”Designation criteria

The DOL guidance identified criteria for an investment within a brokerage window or similar plan to be considered a designated investment alternative: “Pending further guidance in this area, when a platform holds more than 25 investment alternatives, the department ... will not require that all of the investment alternatives be treated ... as designated investment alternatives if the plan administrator:

”makes the required disclosures for at least three of the investment alternatives on the platform that collectively meet the "broad range' requirements in ... ERISA”; and

”makes the required disclosures with respect to all other investment alternatives on the platform, in which at least five participants and beneficiaries, or, in the case of a plan with more than 500 participants and beneficiaries, at least 1% of all participants and beneficiaries, are invested on a date that is not more than 90 days preceding each annual disclosure.”

And if “significant numbers” of participants and beneficiaries choose specific investments offered in a brokerage window, the plan fiduciary has an “affirmative obligation” to examine these investments to determine if they should be treated as designated investment alternatives, the document said.

“The fiduciary obligation to designate a manageable number of investment options is a critical part of making these retirement plans work for America's workers,” said DOL spokesman Michael Trupo. Evaluating brokerage windows is “critical,” Mr. Trupo said in an e-mailed response to questions.

Financially unsophisticated participants “may need guidance when choosing their own investments from among a large number of alternatives,” he wrote. “Designating specific investment alternatives also enables participants and beneficiaries ... to compare the cost and return information for the designated investment alternatives when they are selecting and evaluating alternatives.” DC industry officials, however, said the DOL has gone too far.

“It seemed like a solution in search of a problem,” said Ms. Eller of Groom Law Group. “Beyond clarifying the rule's application to brokerage windows, it didn't seem necessary for the Labor Department to address this issue at all.”

The new DOL document “deviates significantly from current regulatory guidance by imposing fiduciary responsibility” on sponsors when participants choose investments in self-directed brokerage accounts, Jennifer Engle, a spokeswoman for Fidelity Investments, Boston, said in an e-mailed response to questions.

“Plan sponsors are expressing serious concerns about (the DOL document) and the lack of clarity about how they should respond,” she added.

Self-directed brokerage windows continue to gain popularity. According to periodic surveys by Aon Hewitt, Lincolnshire Ill., 29% of defined contribution plans offered self-directed brokerage windows in 2011, steadily increasing from 12% in 2001 when the firm began tracking them. In plans for which it was offered, this investment option accounted for an average 6% of total plan assets last year.

“Now, in certain circumstances, plan sponsors have to dedicate resources (to) tracking how many people invest in those (brokerage window) funds,” said Alison Borland, vice president for retirement product strategy at Aon Hewitt, referring to the DOL guidance. “Additionally, this will result in more fiduciary responsibility and oversight.”

The DOL guidance “has added a whole new level of confusion” for participants, said Marina Edwards, a senior consultant in the benefits advisory and compliance group for Towers Watson & Co. in Madison, Wis. “It will confuse people more than it will help them.”

Ms. Edwards has fielded anxious calls from clients. “This is a nightmare,” she said, quoting one unnamed client.

Another client is worried about extra fiduciary responsibilities, Ms. Edwards said. A quick review of this sponsor's self-directed brokerage indicates that enough participants have invested in more than 100 of the funds to trigger the designated investment alternative outlined in the DOL guidance. “They have 15 core funds, and now they'll have exposure to 100 more,” she said.

One client, which had planned to add a brokerage window in the fall, has been told by its ERISA counsel to “seriously reconsider,” she said. Another is pressing ahead to add the option in July.